Earn-Outs in M&A

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This article was prepared for and first appeared in Which Lawyer in Romania 2021

Author: Corina Dumitru

An earn-out is a contractual mechanism pursuant to which part of the purchase price is contingent upon the target company’s future performance or upon achieving a certain milestone or both.

The structure of an earn-out differs from a deal to another depending on the size and nature of the business, the expectations of the parties, the future involvement of the seller in the acquired business, the integration of the acquired business in the buyer’s operations.

Earn-out arrangements are complex and may be contentious. It is therefore essential to carefully consider all elements, to involve legal, financial, tax and accounting consultants from an early stage and to reflect the terms agreed by the parties in clear, unambiguous, contractual provisions.

Why to use an earn-out

An earn-out generally serves to overcome the difference in price expectations between the seller and the buyer. It may also be designed to tie the seller to the company for a certain period of time to ensure a smooth transition, the transfer of know-how and the retention of key personnel.

An earn-out allows the seller to participate in the future performance of the business and the buyer to link the price to the performance of the company after acquisition. However, it comes with various difficulties, mainly deriving from the determination of the earn-out amount and the need to protect not only the earn-out for the sellers, but also the development of the business by the buyer in accordance with its strategies.

Earn-outs may be of particular importance in periods of market uncertainty, when valuation of the business becomes more complex, risks and prospects are more difficult to determine and the gap between the views of the seller and the buyer is more difficult to overcome.

Determination of the earn-out amount

Earn-outs are generally performance-based and are calculated by reference to certain financial metrics, such as revenues, EBITDA, gross margin, net income, of the acquired business over a certain period of time. It is key that all parameters are clearly defined (including by way of formulae, pro forma accounts, example calculations), that financial and accounting specialists are involved in shaping the mechanics and that a clear determination mechanism is agreed upon (for example, by referring the calculations to an independent expert in case of disputes). Depending on the business and the buyer’s objectives, there may be other aspects to be considered in the determination of the earn-out amount, apart from the metrics, including the integration of the acquired business into the buyer’s organization and the consequences of such integration.

An earn-out may also be based on non-financial indicators, such as obtaining a regulatory approval, completion of a specific project, registration of a patent, successful launch of a product, award of certain key contracts or retention of the management or the core team.

Earn-out period

Typically, the earn-out arrangement spans over a period between 1 to 3 years after acquisition. However, its length depends on various factors, including the risk appetite and the objectives of the parties, the business plan, the elements based on which the earn-out is calculated, the restrictions imposed on the parties, the need to have the seller involved in the business.

Protection mechanisms

The seller would seek to protect its earn-out by imposing various restrictions on the buyer and the conducting of the business after acquisition, more so if it does not continue to be involved in the business. On the other hand, the buyer would wish to ensure that the business can be conducted according to its own plans and objectives and integrated into its operations. Finding the middle ground accommodating both the seller’s legitimate interest to earn-out and the buyer’s right to conduct the acquired business is fundamental for earn-out arrangements. In constructing the protection mechanisms, the parties might consider certain objective elements, such as an agreed business plan that cannot be departed from without the other party’ consent. Competition issues should also be considered when discussing the various restrictions.

If the seller remains with the company after acquisition, the parties will also need to agree on the cases in which termination of contractual arrangements with the company lead to the loss of the earn-out (the so-called “bad leaver” clauses). This is a key and always controversial aspect, that adds to the complexity of the earn-out mechanism.

Tax concerns

Earn-outs are sensitive from a tax perspective, hence tax implications should be considered from the outset as they may impact the commercial and legal aspects.

In case of a seller involved in the company not only as a shareholder but also as an employee or director, there is a risk that the tax authority treat the earn-out not as a capital but as a salary income, with corresponding consequences, including higher taxes payable.

Anti-embarrassment clause

A seller may be expected to ask for the payment of the earn-out, irrespective of the achievement of the earn-out targets, if the buyer further sells the company to a third party within the earn-out period. This way, the seller protects against being seen as selling the business at a very low price and ensures that it will not deal with the subsequent buyer with respect to its earn-out.


The payment of the earn-out amount by the buyer may need to be secured, in particular if the buyer is an acquisition vehicle. Security mechanisms such as escrow account, parent or bank guarantee may be set up. From the other side, the right of the buyer to set-off any claims towards the seller under the transaction documents against earn-out amounts would work as a security for the buyer against the risk of payment of the relevant damages by the seller.

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